Identifying the Relationship between Trade and Exchange Rate Volatility

We develop a model of international trade in which trade depresses real exchange rate volatility and exchange rate volatility impacts trade in products differently according to their degree of differentiation. In particular, commodities are less affected by exchange rate volatility than more highly differentiated products. These insights allow us to simultaneously identify both channels of causation, thereby structurally addressing one of the main shortcomings of the existing empirical literature on the effects of exchange rate volatility on trade — the failure to correct for reverse causality. Using disaggregate trade data for a large number of countries for the period 1970-1997 we find strong results supporting the prediction that trade dampens exchange rate volatility. We find that once we address the reverse-causality problem, the large effects of exchange rate volatility on trade found in some previous literature are greatly reduced. In particular, the estimated effect of currency unions on trade is reduced from 300 percent to be between 10 and 25 percent.

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